Flashman Letters

Adair Turner says that some central banks, particularly Japan's, will never shrink their balance sheets

http://www.project-syndicate.org/commentary/adair-turner-says-that-some-central-banks--particularly-japan-s--will-never-shrink-their-balance-sheets

The rarely admitted truth, however, is that there is no need for central banks’ balance sheets to shrink. They could stay permanently larger; and, for some countries, permanently bigger central-bank balance sheets will help reduce public-debt burdens.

As a recent IMF paper by Carmen Reinhart and Kenneth Rogoff illustrates, advanced economies face debt burdens that cannot be reduced simply through a mix of austerity, forbearance, and growth. But if a central bank owns the debt of its own government, no net public liability exists. The government owns the central bank, so the debt is to itself, and the interest expense comes back to the government as the central bank’s profit. If central bank holdings of government debt were converted into non-interest-bearing perpetual obligations, nothing substantive would change, but it would become obvious that some previously issued public debt did not need to be repaid.

U.S. Criticized for Lack of Action on Mortgage Fraud

Four years after President Obama promised to crack down on mortgage fraud, his administration has quietly made the crime its lowest priority and has closed hundreds of cases after little or no investigation, the Justice Department’s internal watchdog said on Thursday.

The report by the department’s inspector general undercuts the president’s contentions that the government is holding people responsible for the collapse of the financial and housing markets. The administration has been criticized, in particular, for not pursuing large banks and their executives.

“In cities across the country, mortgage fraud crimes have reached crisis proportions,” Attorney General Eric H. Holder Jr. said at a mortgage fraud summit in Phoenix in 2010. “But we are fighting back.”

The inspector general’s report, however, shows that the F.B.I. considered mortgage fraud to be its lowest-ranked national criminal priority. In several large cities, including New York and Los Angeles, F.B.I. agents either ranked mortgage fraud as a low priority or did not rank it at all.

Related Links

• Inspector general's report

The F.B.I. received $196 million from the 2009 to 2011 fiscal years to investigate mortgage fraud, the report said, but the number of pending cases and agents investigating them dropped in 2011.

“Despite receiving significant additional funding from Congress to pursue mortgage fraud cases, the F.B.I. in adding new staff did not always use these new positions to exclusively investigate mortgage fraud,” the report says.

via dealbook.nytimes.com

If you really want a headache....

The Paper

The paper - Money Creation in the Modern Economy

http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf

The paper is impressive in that it also makes a number of insightful points apart from the issue of the money multiplier – points not often seen elsewhere – and treated here matter-of-factly and effectively. Moreover, its scope extends well beyond money creation and into a wider description of the dynamics of money circulation and bank risk management.

The section on quantitative easing in particular is excellent because (unusually) it immediately identifies a fundamental aspect of QE overlooked by most commentators – which is that QE routinely creates broad money as well as bank reserves. I suspect future economic history books will look back on this QE episode and point to a general failure by present day analysts and economists to consider this balance sheet aspect more thoroughly in figuring out just how QE works.

QE is not just about bank reserves. In fact, the bank reserve effect is arguably the least important feature of QE – although that opinion may not exactly warm the cockles of monetarist hearts. The paper appropriately refers to reserves as the “by-product” of QE (a concept I invoked in a back and forth here with Scott Sumner in his early blogging days, roughly 5 years ago).

There are additional points made about QE that are notable – that the central bank isn’t giving the banks “free money” for example. Again, a full appreciation of this aspect requires an understanding of banking system liability effects of QE – including potential or actual pricing effects on the liability side (this may become more of an issue after zero bound lift off has commenced for those systems that are currently parked next to the zero bound).

http://monetaryrealism.com/money-creation-in-the-modern-economy-bank-of-england/

 

Critique 1

http://www.themoneyillusion.com/?p=26355#

I recall that Paul Krugman was once criticized for saying banks can “lend out” reserves.  I generally don’t say things like that because I ignore banks.  But there was nothing wrong with Krugman’s claim.  Yes, it’s true that when money is lent out and the borrower withdraws the loan as cash, the borrower does not literally “hold reserves.”  So the BoE is technically correct. But that’s a meaningless distinction, as it’s all base money, and reserves are just the name given to base money when held by banks, and cash is the name given to base money held by non-banks.

One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.

In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.

I recall that once when Krugman was faced with this sort of argument he said something to the effect of “it’s a simultaneous system.” Banking is an industry that provides intermediation services.  Banks have balance sheets with assets and liabilities. It makes no sense to say that one side of the balance sheet causes the other.  If people want to borrow more, then bank interest rates on loans and deposits adjust in such a way as to provide a new equilibrium, probably with a larger balance sheet.  But that’s equally true of the situation where people want to hold larger amounts of bank deposits.  It’s completely symmetrical. Consider the real estate broker industry.  Does more people buying houses cause more people selling houses, or vice versa?

 

Critique 2

So in equilibrium, when the actual stock of base money is equal to the quantity of base money demanded, the stock of broad money must be a multiple 1/r of the stock of base money. And if the central bank shifts the supply function of base money $1 to the right, that must increase the equilibrium stock of broad money by $(1/r). Just like the first-year textbook says it will!

Now you might object that modern central banks don't care about the stock of base money (except when they are doing QE), and target things like inflation instead (except for 8 week periods when they target an interest rate). OK. But if the central bank wanted a temporary increase in the inflation rate, and so a permanent rise in the price level, it would need to shift the supply function of base money, to create a permanent rise in the monetary base, and a permanent rise in broad money, and the textbook money multiplier would tell us that broad money would increase by 1/r times the increase in base money.

One simple (first-year textbook) general theory to rule them all!

What is the underlying problem here? Why do monetary economists resist this very simple and very general theory of monetary policy? The underlying problem is revealed in this quote:

"Like reductions in Bank Rate, asset purchases are a way in which the MPC can loosen the stance of monetary policy in order to stimulate economic activity and meet its inflation target."

It assumes that interest rates are a measure of the "stance of monetary policy". If interest rates were an adequate measure of the "stance of monetary policy", the Bank of England would not need QE. And you cannot define the stance of monetary policy by taking some sort of average of interest rates and QE. A permanent increase in the target price level would mean a permanent increase in the money base but would have no obvious implications for interest rates. A permanent increase in the inflation target would mean a permanent increase in the growth rate of the money base but would mean higher nominal interest rates. There is no monotonic mapping from loose monetary policy into low interest rates. Thinking about monetary policy in terms of interest rate policy just doesn't work. It doesn't work in theory, and it doesn't work in practice. That's why the Bank of England is doing QE, and having to re-introduce the old general theory as a special theory of how monetary policy works.

http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/03/one-general-theory-of-money-creation-to-rule-them-all.html#more

Banking theory disguised as monetary theory? This is starting to give me a headache

I recall that Paul Krugman was once criticized for saying banks can “lend out” reserves.  I generally don’t say things like that because I ignore banks.  But there was nothing wrong with Krugman’s claim.  Yes, it’s true that when money is lent out and the borrower withdraws the loan as cash, the borrower does not literally “hold reserves.”  So the BoE is technically correct. But that’s a meaningless distinction, as it’s all base money, and reserves are just the name given to base money when held by banks, and cash is the name given to base money held by non-banks.

One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.

In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.

I recall that once when Krugman was faced with this sort of argument he said something to the effect of “it’s a simultaneous system.” Banking is an industry that provides intermediation services.  Banks have balance sheets with assets and liabilities. It makes no sense to say that one side of the balance sheet causes the other.  If people want to borrow more, then bank interest rates on loans and deposits adjust in such a way as to provide a new equilibrium, probably with a larger balance sheet.  But that’s equally true of the situation where people want to hold larger amounts of bank deposits.  It’s completely symmetrical. Consider the real estate broker industry.  Does more people buying houses cause more people selling houses, or vice versa?

via www.themoneyillusion.com

China is shaking, sending ripples from Perth to Peru - China seems to be the subject du jour

China’s consumption of other commodities also accounts for a hefty share of global production, though not as large as for base metals. In the case of non-renewable energy resources, the proportion is 20%, and for major agricultural crops, it’s 23%. (IMF, China’s Impact on World Commodity Markets, http://www.imf.org/external/pubs/ft/wp/2012/wp12115.pdf). China’s significance arises not only because its consumption represents such a large share of metals production, but also because of the intensity of its usage. So, for example, if you look at the IMF paper, you can see the consumption of base metals per capita over time set against real GDP per capita for a group of countries and regions. China commodity intensity has ben growing rapidly and is unusually high for a country at its stage of development, especially when judged against some of its peer group, including Brazil.

There’s also a murkier side to Chinese commodity consumption that hinges around the use of copper especially as collateral for loans, or access to finance – and also as a means of raising finance abroad and bringing it on-shore to spend or lend. In a nutshell, this revolves around the purchase of copper abroad, using trade finance, and subsequent sale generating a capital inflow. In reality, it’s more complicated but still classified as speculation. (see for example, a 2011 explanatory piece by FT Alphaville’s Izabella Kaminska, http://ftalphaville.ft.com/2011/03/15/514921/simply-amazing-commodity-collateral-shenanigans-in-china/, and more recent ones by David Keohane at http://ftalphaville.ft.com/2014/02/21/1778262/still-waiting-for-that-china-copper-unwind/, and Lucy Hornby at http://www.ft.com/cms/s/0/a8e4ed88 a9cc-11e3-8bd6-00144feab7de.html#axzz2vlzSk7Mr)

It is self-evident that if base metals prices fall far enough, all participants in the credit chains will suffer losses, and that if they fall too far, distressed sales could send stronger ripples through the heavy industry complex, and metals import sectors as well as to global producers. Add an end to the carry trade of raising cheap US dollar finance abroad, and you can see why a lot of people are talking – wrongly – about a Chinese Bear Stearns or Lehmans moment. It’s wrong because the consequences of what is more accurately a Minsky Moment are highly unlikely to compare with the financial implosion that erupted in the West in 2008/09. China’s financial system is state owned and guaranteed, the country is a net creditor with a high savings rate, and it has financial resources-a-plenty with which to recapitalise banks, and finance losses. But – and it’s an important but – there will be a cost in terms of growth, jobs and the pace of development, and poignantly to the whole rebalancing agenda. Someone, after all, has to pay for a banking crisis, and the household sector is the most likely to do so through further reductions in nominal and real interest rates precisely when China’s market aspirations call for the opposite.

Some people argue that short-term problems aside, the future for base metals remains rosy since China is so far behind the US, Europe, and Japan when it comes to per capita comparisons of electric power consumption, automobile ownership, rail track, highways and bridges and so on. This is a little naive, given that it neglects the important point that high per capita infrastructure levels have to generate productivity growth and be commercially viable. But you could make the case that the structural demand for steel, iron ore, copper and much else will in time sustain metal prices over the lo

via www.georgemagnus.com

Video Gloom China Edition

3 hours of Chinese Gloom for a low attention span Friday:

Amazing documentary on Chinese property bubble

http://www.youtube.com/watch?v=-a9Xuyw9l3Y

Jim Chanos

http://www.youtube.com/watch?v=5jMLulZnT1g

Michael Pettis: More technical less anecdotal

http://www.youtube.com/watch?v=pXu8FQC3Z38

 

 

Tom Holland on teh origins of Islam. The book is great - but long - here is the gist in a bit more than an hour

via vimeo.com

100 years of excess returns: No, they are not (statistically) significant.

In the case of the US stock market you are not just cherry picking, but double cherry picking.  You are selecting one of the most impressive economies in the world over the past 100 years.  A country that never adopted socialism, was never destroyed by war, revolution or hyperinflation.  Even many major economies like Germany, Japan, Russia and China suffered enormous problems at various stages of the past 100 years.  The commenter “dlr” shows that the US stock market has outperformed all of the other big economies.  And he compares the US to other countries that have done relatively well, leaving out places like Russia, China, Argentina, Venezuela, etc.  So by looking at the US you have cherry picked the most successful big economy in world history, during its golden age.  But that’s not enough to explain the entire equity premium, as dlr notes.  Other countries also have rather large returns.  

This leads to the second form of cherry picking, you are studying what has turned out (ex post) to be the Cadillac of investments—stocks. Today we think of stocks as a perfectly normal investment.  I’ve had all my 401k in stocks for almost my entire working life, and that’s not considered particularly weird.  But 100 years ago stocks did not have the prestige they have today.  Bonds and bank accounts would have been more typical investments.  I would have had railroad bonds in my 401k.  The stock market turned out to be the premier investment of the past century (for many complex and unexpected reasons), but no one knew that in 1914.

I know that people will want to latch on to the 100 years of data—surely that is statistically significant?  I will admit that if stocks consistently earned large returns then you could say that investors should have caught on.  Suppose that the excess returns were always positive, but ranged from 1% to 9%, averaging 5%.  Then yes, 100 years would be enough.  But look at this data for the Dow:

March 11, 1914   Dow = 81.57,  CPI = 9.9  real Dow = 8.24

August 12, 1982,  Dow = 776.92   CPI = 97.7   real Dow = 7.95

In real terms the Dow went nowhere in 68 years.  Yes, the total real returns were positive because of dividends, and indeed probably larger than bonds (which were crushed by unexpected inflation after we left gold.)  But a real yield equal to slightly less than the dividend yield is not all that impressive for 68 1/2 years.  Now look at the next 18 years:

April 11, 2000  Dow = 11287   CPI = 171.3    real Dow = 65.9

The real Dow exploded more than 8-fold.  That’s an awesome return, which doesn’t even include dividends.  And then another 14 years of so-so, even given the extraordinary bull market of recent years:

March 11, 2014   Dow = 16351   CPI = 233.9   real Dow = 69.9

Yes, other indices like S&P 500 would probably have been different.  The early period would probably look better, weakening my argument.  But the 1982-2000 explosion would look even bigger, and the 2000-2014 slowdown even worse, both strengthening my argument.  The basic picture is that in 1982-2000 the market experienced something analogous to the “inflation” of the early universe, when values just exploded.

My pathetic attempt to explain that growth would involve many factors such as slowing inflation and lower taxes on capital gains.  But one factor might have been a growing awareness among investors that with modern investing techniques and longer lives and lots of people putting money away for 40 or 50 years in 401ks thos

via www.themoneyillusion.com

Inequality And The Weak Recovery

While household debt dynamics appear to have stabilized and deleveraging is largely complete, income inequality can continue to rise in the U.S. and consumption remain depressed because wealthier households typically save a greater share of income and have a lower propensity to spend per dollar of income. In addition, permanently tighter lending standards have left many households unable to access credit or unwilling to do so. So it is both a demand and a supply story as it relates to credit. But the main point is that income gains have been mediocre for a broad swath of middle income households for some time, and borrowing temporarily masked the demand drag. In combination these factors have been a contributing factor to the slow recovery of U.S. consumption and economic growth.

via www.businessinsider.com

What Putin Really Wants - Interesting

At present, Mr. Putin is seeking to strong-arm the new, weak and unstable government in Kiev into agreeing to full autonomy for Crimea rather than risk a full scale invasion into Ukraine and a partition that chops off the country’s entire south and east. The intimidated government is likely to be compelled to accept this compromise. For its part, in exchange for major Ukrainian concessions, Russia is likely to recognize the new Ukrainian government, withdraw its support for Viktor F. Yanukovych and relinquish the threat of the use of force.

This strategy seems to be paying off already. The mere specter of a Russian intervention was enough for the new Ukrainian government to abandon its threat of reducing autonomy for the “rebellious” peninsula. The acting president, Oleksandr V. Turchynov, has also announced that he will veto the scandalous Feb. 24 law that canceled Russian’s status as an official language. The West is likely to accept any agreement that does not formally violate the territorial integrity of Ukraine. Their rhetoric notwithstanding, neither the United States nor the European Union has any desire for direct confrontation with Russia.

It wouldn’t be surprising if Mr. Putin soon magnanimously announced his readiness to compromise and “guarantee the territorial integrity of Ukraine,” which the Kremlin actually never intended to violate in the first place.

That’s because Russia has a strong interest in nominally retaining Crimea as part of Ukraine. From the disintegration of the Soviet Union onward, Crimea, with its traditionally separatist leanings, was always a destabilizing factor. It served as a direct avenue of Russian pressure on Ukraine, and also guaranteed almost a million “pro-Russian” votes in Ukrainian elections, ensuring the dominance of the pro-Russian eastern half of the country over the nationalist western half.

If the Ukrainian nationalists had been smarter and more farsighted, they themselves would have advocated a renunciation of claims to Crimea in order to remove this needle in their side, but their desire for a Greater Ukraine has trumped sober political calculations.

Mr. Putin is a more farsighted and coldblooded calculator. He will therefore strive to keep Crimea as part of Ukraine, but as a reinforced instrument of Russian influence over politics in Kiev — and a powerful example for pro-Russian populations in other regions.

via www.nytimes.com